Governance and disclosure failures preceded CEO's death

The death of railroad legend and CSX Corp. CEO Hunter Harrison was a tragedy for his family and a shock to CSX shareholders, who on Friday cut the company’s market capitalization by $4 billion.

It also marked, in my view, the culmination of a series of governance and disclosure failures at CSX that highlight a gaping hole in Securities and Exchange Commission rules.

Mr. Harrison was hired by CSX in March in response to pressure by activist investor Mantle Ridge LP. The then-incumbent board was clearly skeptical, pointing out among other things that the aggregate value Mr. Harrison’s proposed compensation package could exceed $300 million over the term of his contract (though Mantle Ridge disputed the calculation) and Mr. Harrison had refused the board’s request for a pre-hire review of his medical records. CSX negotiated the vesting of most of those benefits and because of his untimely death, Mr. Harrison’s compensation was probably not more than a few million dollars.

But part of the deal involved CSX assuming responsibility up-front for $84 million in payments (plus a tax “gross up”) related to Mr. Harrison’s departure from Canadian Pacific Railway Ltd., his previous employer. That turned out to be pretty expensive considering Mr. Harrison held the CSX job for less than ten months.

Despite its skepticism, the board avoided a fight and in February passed the buck to shareholders. It told CSX shareholders that it was up to them whether to hire Mr. Harrison, without the board even making a recommendation. Shareholders could rightly ask what the board was being paid to do if it couldn’t provide leadership on who should be CEO and the terms of employment.

But the issue wasn’t over. Three weeks later it seems to me that CSX backed its shareholders into a corner by entering into an agreement with Mantle Ridge under which Mr. Harrison immediately became CEO and five new directors were appointed to the CSX board. The only thing that was left to shareholders was whether to assume responsibility for those $84 million in payments (plus up to $23 million in tax payments) which were put to shareholders at the annual meeting in June. The board continued to make no recommendation on the proposal and noted that one of the negatives with the deal was the “risk that Mr. Harrison may not be able to continue to serve as CEO over the course of his four-year employment agreement, whether due to death, disability or other reasons.”

What choice did that leave shareholders? Mr. Harrison had already been in place three months when the meeting rolled around and said he would quit if shareholders didn’t approve.

And what about the analysis of Mr. Harrison’s health issues? There was no information on that issue other than acknowledging that his health was a risk. In May, before the vote on the big payment, the Journal reported that Mr. Harrison had an undisclosed medical condition that forced him to work from home many days and he sometimes used an oxygen machine to help him breathe.

When questioned by the Journal, Mr. Harrison declined to discuss the details of his condition and said the board decided details of his health aren’t isn’t sufficiently material to the company’s performance to disclose. In a regulatory filing in response, the company said that “as a matter of policy we do not comment on health related matters of any CSX executive,” and pointed out Mr. Harrison “has been and continues to be actively and deeply involved on a daily basis.”

Wow. The CSX directors might want to call their lawyers. Given the market’s reaction to Mr. Harrison’s death, that looks like a pretty bad call.

Some of the blame for this and other companies’ CEO health disclosure issues rests firmly in the SEC’s lap: Despite the voluminous information required by SEC rules on executives and directors, there is no specific requirement to disclose a CEO’s significant health issues.

CSX’s nightmare may not be over. Plaintiffs’ law firms look for companies to sue that have precipitous market drops following a material announcement. And although there is no line item for disclosure on health issues, companies are still prohibited from omitting disclosures that make the disclosures they do make misleading. Should there be such litigation, it could go on a long time and provide further distraction.

To be fair, none of this means that the decision to hire Mr. Harrison was a mistake or that any errors were made from a legal perspective. Businesses must balance risks and rewards of their actions all the time; not every bet pans out. And the company says that it will still be able to “capitalize on the changes” that Mr. Harrison made. And shareholders may agree: despite the market’s reaction to Mr. Harrison’s death, CSX stock still trades significantly above its price before Mr. Harrison surfaced at CSX.

The bottom line is that shareholders got neither the leadership nor the disclosure that they deserved (even if the disclosure met the legal minimums) in making the management change.

Here is another data point: Two years ago, while Mr. Harrison was leading CP, it made a hostile takeover offer for Norfolk Southern, putting forward similar arguments on how he could improve the target company’s performance. Norfolk Southern resisted the takeover. Based on the current market price, the package of cash and stock CP offered would have had a value today of around $113 per Norfolk Southern share.

Norfolk Southern shares closed Friday at $144. Mr. Harrison had a stellar reputation, but Norfolk Southern seems to have done fine without him.